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What’s your fraud IQ?

At some point in nearly every CPA’s professional experience, he or
she encounters a transaction or situation that stands out from the
others—one that just doesn’t make sense. Many of these occurrences
turn out to be erroneous or to have an unobvious, yet legitimate,
reason behind them. But some have a more sinister explanation. Do you
know how to spot the red flags of a fraudulent transaction? Are you
able to effectively evaluate the warning signs? Take this quiz to test
your knowledge of the techniques that can help detect and analyze
potential fraud.

1. Confirming customers’ outstanding account balances and examining
journal entries for false write-offs of accounts receivable would be
most helpful in detecting which of the following schemes?

2. Which of the following circumstances best indicates that
contractors are colluding to manipulate the contract bidding process?

a. All of a procuring company’s contracts are awarded to the same
contractor.b. Different contractors bid for each of the
procuring company’s contracts.c. More competitors than normal
submit bids for a contract. d. Bid prices fall when a new
contractor enters the competition for contracts.

3. During an audit of ABC Wholesale Inc., Leanna, CPA, identifies
several sales transactions that were canceled after the merchandise
was recorded as having been shipped. Additionally, she notes that the
company’s cost of goods sold unexpectedly increased as a percentage of
sales. Which of the following fraud schemes are these findings most
likely to indicate?

4. Miles is reviewing his company’s payroll records when he notices
an employee who has no taxes or insurance withheld from his paycheck.
In addition, the employee’s Social Security number is the same as
another employee’s Social Security number. Which of the following
schemes do these facts most likely point to?

5. A nonlinear relationship between sales and returns and allowances
over a period of time, when the relationship is expected to be linear,
might indicate that a cash larceny scheme is taking place.

a. True.b. False.

6. Grey Co.’s management is engaging in a financial statement fraud
scheme in which revenue is being artificially inflated, with the
corresponding debit recorded to fixed assets. All of the company’s
sales are made on credit. Which of the following effects does this
scheme have on the accounts receivable turnover?

8. Beatrice, the accounting manager at Ajax Inc., just received a
phone call from one of the company’s vendors regarding numerous
instances in which duplicate payments were received from Ajax during
the last several months. The representative said the vendor needs the
duplicate payments to stop, as continually issuing refund checks for
the extra payments is making its accounting processes quite difficult.
Beatrice then checked the vendor’s account on Ajax’s books, but she
noted no sign of duplicate payments or refunds. Which of the following
fraud schemes does this situation most likely indicate?

1. (b) Skimming schemes involve the theft of
incoming cash receipts before they have been recorded as received on
the company books. In a scheme in which a perpetrator steals incoming
customer payments, the theft results in a customer account balance
that is overstated; that is, the amount the customer truly owes is
less than the amount reflected on the customer’s account receivable.
Consequently, confirming outstanding account receivable balances
directly with customers can help identify any accounts on which a
payment was made but was diverted before being recorded. In addition,
a fraudster who is skimming customer payments might attempt to conceal
the theft by adjusting the accounts receivable balance through credits
or write-offs to certain customer accounts. Analyzing adjusting
entries made to accounts receivable can uncover any credits that were
recorded without authorization or justification and that thus merit
further investigation.

2. (d) Some dishonest contractors collude with one
another to circumvent the competitive bidding process in order to
remove other vendors from the competition for contracts or to
artificially inflate the prices of goods and services. As a result of
these schemes, the procuring entity loses the benefits of free and
open competition, including fair pricing, reasonable performance, and
transparency in the procurement transactions. Some common red flags
that can indicate collusion among contractors include the following:

The same contractors bid on each project or product.

The winning bid for contracts consistently appears too high.

All contractors submit consistently high bids.

Qualified contractors do not submit bids.

Fewer competitors than normal submit bids on a project or product.

When a new contractor enters the competition, the bid prices begin
to fall.

There is a rotational pattern to the winning bidders.

3. (a) To conceal a theft of inventory, the
perpetrator might record false sales transactions to make it appear
the missing goods were sold rather than stolen. The downside of this
approach is that the books reflect a payment due from a customer for
the fictitious sale—a payment that will obviously never be received.
The perpetrator can mitigate this red flag of the scheme if he or she
is in a position to subsequently adjust the fictitious transaction,
such as by canceling the sale after the goods are shown as having been
shipped. Although such an adjustment still leaves a trail in the form
of canceled sales for which the merchandise was shipped, such an
anomaly is less likely to be detected without targeted audit
procedures than uncollected receivables would be.

An unexpected increase in cost of goods sold as a percentage of sales
is another common byproduct of an inventory theft scheme. Inventory
shrinkage, including that caused by theft, must eventually be
accounted for on the company books, often through a debit to the cost
of goods sold account. Unless the perpetrator also records and leaves
fictitious sales on the books, such an entry results in cost of goods
sold increasing without a corresponding increase in sales. When this
trend is noted without a reasonable explanation (e.g., an increase in
the purchase price of inventory), it should be explored for additional
signs of fraud.

4. (c) In a ghost employee scheme, an individual who
does not work for the organization is added to the payroll to generate
fraudulent paychecks, which are then intercepted by the scheme’s
perpetrator. When setting up the ghost employee in the payroll file,
the perpetrator often simply uses his or her own address, Social
Security number, or other identifying information; consequently, the
presence of duplicate records for these fields can be a red flag of a
ghost employee scheme. Additionally, ghost employees often have no
taxes, insurance, or other normal deductions withheld from their
paychecks. Consequently, identifying employees who have no payroll
deductions taken can be an easy and effective method for uncovering
payroll manipulations.

5. (a) In general, there should be a linear
relationship between sales and returns and allowances over a given
period. Without a valid explanation, such as a known product defect, a
nonlinear relationship between these amounts might point to a fraud
scheme. Cash larceny is one potential scheme that can affect this
relationship; these schemes involve the theft of incoming payments
that have already been recorded on the victim company’s books. To
conceal these schemes, the perpetrator often records a sales return or
allowance as a way to justify the removal of the missing money.
Consequently, an unexpected increase in the amount of returns and
allowances, especially without a corresponding increase in sales, can
indicate that a cash larceny scheme is occurring and thus merits
further scrutiny.

6. (a) The accounts receivable turnover is
calculated as annual net sales on account divided by average annual
accounts receivable. This ratio normally remains level, even as sales
volume increases or decreases, absent other changes that could affect
the ratio’s components. Consequently, unexpected fluctuations in this
ratio merit investigation—and might help identify fraud. For example,
if a company is recording fictitious sales on the books but balancing
those entries with a debit to an account other than accounts
receivable, such as fixed assets, the numerator of the accounts
receivable turnover (sales) is inflated without a corresponding
increase in the denominator (accounts receivable). The result is an
unexpected increase in the ratio.

7. (b) According to the 2014 Report to the
Nations on Occupational Fraud and Abuse by the Association of
Certified Fraud Examiners, 42% of corruption cases are detected by tip
(see acfe.com/RTTN for the full
report). In contrast, management review, the second most common
detection method for corruption cases, uncovered 16% of these schemes.
External audits and reports from law enforcement accounted for far
fewer discoveries of corruption, just 3% and 2%, respectively, of
these schemes.

Additionally, of the whistleblower tips that led to the investigation
of the cases, 49% of those tips came from an employee, and another 15%
came from an anonymous source. Consequently, it’s extremely important
to include material specifically on the warning signs of these schemes
in an organization’s employee antifraud and compliance training
programs. Some warning signs that employees should be made aware of include:

An employee who regularly accepts inappropriate gifts from clients
or vendors.

An employee who often makes excuses for deficiencies in a third
party’s products or services.

An employee who does not file conflict-of-interest forms.

An employee who has an unusually close, undisclosed relationship
with a vendor or customer.

A vendor or customer who routinely offers inappropriate gifts or
lavish business entertainment.

A vendor or contractor who is consistently awarded work without
any apparent competitive advantage.

8. (d) Pay-and-return billing schemes are a
form of false billing in which the fraudster intentionally manipulates
the payment on a legitimate invoice to a real vendor, requests a
refund for the overpayment, and diverts the refund for personal gain.
The payment manipulation might take the form of an overpayment, a
duplicate payment, or a payment “accidentally” sent to the wrong
vendor. To cover schemes involving duplicate payments on the company
books, the perpetrator often creates a fictitious vendor with a name
very close to the name of an existing vendor and records the second
payment on the fake vendor’s account. Consequently, tests to identify
vendors with duplicate or very similar names and to detect payments to
unapproved vendors can be extremely useful in identifying these types
of schemes.

SCORING

If you answered all eight questions correctly, congratulations. Your
thorough knowledge of the hallmarks of fraud will help you effectively
identify potentially fraudulent conduct. Keep up the good work.

If you answered six or seven questions correctly, you’re on the right
track. Continue to build on your knowledge of fraud detection and
investigation.

If you answered fewer than six questions correctly, you may want to
brush up on your antifraud knowledge. Enhancing your understanding of
the red flags of fraud will help ensure that you have what it takes to
keep fraud from going unnoticed.

Andi McNeal (amcneal@acfe.com) is director of research for the Association of Certified Fraud Examiners.

To comment on this article or to suggest an idea for another
article, contact Jeff Drew, senior editor, at jdrew@aicpa.org or 919-402-4056.

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